Euro heading for 3-year highs as ECB sees muted inflation impact

Mon Mar 10, 2014 1:13pm EDT

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By Anirban Nag

LONDON, March 10 (Reuters) - The European Central Bank's decision to leave monetary policy unchanged, and its seemingly relaxed attitude to the impact of a strong euro on deflation, may have put the single currency on course to reach its highest levels in nearly three years.

If the euro zone economy shows more signs of recovery in coming months and U.S. data remains patchy, the euro could rise towards $1.45 - a level seen in mid-2011 - before the ECB expresses discomfort with the exchange rate.

ECB President Mario Draghi suggested at a news conference after last Thursday's Governing Council meeting that economic recovery in the euro zone was on track and did not require a shift in monetary policy.

His comments sent the euro to a 2 1/2 year high of $1.3915 and analysts expect the currency to rise initially to $1.40 in coming weeks.

Although one ECB policymaker, Christian Noyer, expressed some unhappiness about the euro on Monday, investors are likely to test the ECB's resolve to keep monetary policy unchanged by adding to long bets on the euro.

"We would not want to go short on the euro and do not rule out a move to $1.40 in the near term given the ECB's stance," said Yujiro Gato, G10 currency strategist at Nomura in London. "But only a move up towards $1.45 would change the ECB's (stance)."

The euro has gained 15 percent against the dollar from 2012 lows as the threat of a euro zone break-up waned and the region's economy has started to pull out of its slump.

However, while a sharply rising currency adds to the risk of deflation in the euro zone, as it lowers prices of imported goods, Draghi said on Thursday that the currency's rise since 2012 lows had pushed down inflation by only 0.4 percentage points.

That has led some analysts to believe the central bank could tolerate the euro strengthening by another 5 percent - to around $1.45 - at which point it would probably be forced to take action to ease policy to boost prices.

"It appears the FX market found Draghi's comments more hawkish than the rates markets did," said Anthony O'Brien, an interest rate strategist at Morgan Stanley.

Draghi's "rule of thumb" comments that "each 10 percent permanent effective exchange rate appreciation lowers inflation by around 40 to 50 basis points," could give the euro a 3-5 percent lift, he said.

After that, the ECB would become concerned about the euro's impact on inflation and consider cutting interest rates. A cut in the deposit rate, now at zero, into negative territory, would have the biggest impact on the euro, analysts say.

SHRINKING BALANCE SHEET

"The ECB is incredibly relaxed about inflation and that means only one thing for the euro - up," said Howard Jones, a partner at RMG Wealth Manager, who does not rule out a move above $1.40, though a lot would depend on U.S. data.

In the options market, risk reversals - a gauge of demand for options betting on a currency rising or falling - , show a lesser bias for a weaker euro against the dollar in the coming four weeks.

Speculators added to bullish bets on the euro in the week to March 4, data from the Commodity Futures Trading Commission shows. But such bets are far fewer than when the euro last rose above $1.45 three years ago.

An unexpected decline in inflation in coming months, or a sudden deterioration in economic data, would pose risks to the euro's advance.

Annual inflation in the euro zone stabilised in February at 0.8 percent but Draghi warned last week that it was still "way below" the central bank's target of just below 2 percent.

For now, though, policy easing bets are being scaled back.

"The ECB's utter inaction leaves investors to seriously question an assumption that policy easing will be forthcoming. If it is not, bearish euro views are subject to revision," said Tom Levinson, currency strategist at ING.

Euro zone banks meanwhile are repaying cheap loans taken from the ECB in late 2011 and early 2012 at the height of the debt crisis. That is likely to reduce excess liquidity in the banking system and push short-term market rates higher, making the euro even more attractive to investors.

The euro's gains accelerated late last week after data from the ECB showed banks were set to repay a big chunk of their emergency three-year loans. That will shrink the ECB's balance sheet just as the U.S. Federal Reserve and the Bank of Japan are expanding theirs by buying bonds, giving investors another reason to buy the euro.

According to a Morgan Stanley analysis, a rise in euro zone money market rates does attract inflows and broadly underpins the euro, which on a trade-weighted basis is trading near its highest level since early November 2011.

Manuel Oliveri a strategist at Credit Agricole, expects the euro to rise to $1.40 and possibly beyond in the near term.

"Draghi more or less indicated that there is no imminent need for additional policy action. This is especially true as medium-term inflation forecasts remain close to target," he said.

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